Canada: ASC Exempt Market Dealer Sweep Prompts Best Practice Guidance

The Alberta Securities Commission (ASC)
recently completed a compliance "sweep" of 66
Alberta-based exempt market dealers (EMDs). The
results of the sweep, which involved EMDs of many stripes, were
released on May 10, 2017 as ASC Notice 33-705 - Exempt Market Dealer
Sweep (Report). Overall, the ASC
found a spectrum of compliance levels. Some firms achieved a high
level of compliance or were found to be "at least generally
compliant". At the opposite end of the spectrum, compliance
levels of certain firms necessitated regulatory action on the part
of ASC staff.

The sweep focused on compliance systems, sales practices and
marketing (including KYC, KYP and suitability) as well as
conflicts, relationship disclosure and client reporting issues. The
EMDs reviewed included some that offer third-party exempt market
products, others that are primarily involved with oil and
gas-related venture capital and private equity (or with hedge funds
and other pooled investment funds investing in publicly traded
securities) and a third group that focus on mortgage-based
investments.

The purpose of the Report is to summarize the results of the
sweep and provide guidance to assist firms in complying with their
regulatory obligations. Some of the highlights are summarized
below.

Know Your Client

Many of the EMDs were deficient in the collection and
documentation of Know Your Client (KYC) information, with required
information often missing from forms. Under CSA Staff Notice 31-336 - Guidance for
Portfolio Managers, Exempt Market Dealers and Other
Registrants, KYC information is to be updated
annually where the EMD is in regular contact with the client and at
the time of each new trade where the EMD acts for the client only
on occasion. Other issues included the misuse of the prospectus
exemption qualification (a serious breach of securities law, as the
Report pointed out) and "investment cap circumvention"
(where the $10,000 cap for non-eligible investors was finessed
through multiple transactions in that amount on the same day).

Know Your Product

Many firms failed to meet Know Your Product (KYP) requirements.
For example, the Report notes a lack of attention to risks related
to the exempt market. Moreover, reliance was placed on third-party
reports and reports prepared by the issuer, with little or no
independent review. The Report states that KYP due diligence should
include (among others) background checks, an assessment of the
issuer's track record, verification of claims in offering
documents and marketing materials, stress testing of the product
with respect to economic and financial variables, an analysis of
pricing and an independent consideration of the risk factors
disclosed in the offering documents.

Suitability

Section 13.3 of NI 31-103 - Registration Requirements,
Exemptions and Ongoing Registrant Obligations (NI
31-103) requires registrants to take reasonable steps to ensure
that a proposed purchase or sale is suitable for the client. The
ASC's expectation that firms will be able to demonstrate
suitability on a trade-by-trade basis was not met in a number of
cases. The ASC noted a mismatch between the assessed risk tolerance
of investors and their investments and concluded that investors
were often invested too heavily in exempt market securities as a
class. Moreover, KYC forms used by many firms did not collect
information about the use of leverage, which can create serious
liquidity problems, particularly when combined with an
over-concentration in exempt securities.

The ASC identifies a number of practices to address
over-concentration in exempt market securities. It also expects
EMDs to have specific policies and procedures to address
suitability for clients over 60, investors with limited knowledge
and other vulnerable investors. These policies and procedures
include:

Enhanced due diligence (focusing on
holdings outside the firm and other illiquid assets, such as real
estate-backed exempt market securities);

"Red flag" second-level
review by the CCO of transactions:

with concentration near or over 10
per cent of net financial assets;

for clients over 60 years of age or
with limited investment knowledge;

that are leveraged; or

in which the client barely qualifies
for the prospectus exemption; and

Sales and Marketing Practices

The ASC reminds EMDs to establish marketing policies and
procedures consistent with the guidance in CSA Staff Notice 31-325 - Marketing
Practices of Portfolio Managers. Other ASC
guidance focuses on review, approval and centralization of
marketing materials as well as procedures for storage and
retrieval. EMDs are encouraged to engage independent third party
service providers to verify performance calculations.

Conflicts of Interest

Under section 13.4 of NI 31-103, firms are required to avoid
conflicts of interest that pose a serious threat to client
interests or market integrity, while mitigating and disclosing less
serious conflicts. Here again, compliance was less than ideal;
while most firms did have some internal controls, policies and
procedures were often insufficient to identify conflicts. The ASC
recommends a product-specific disclosure form that discusses
conflicts of interest that apply to a particular product. The ASC
wants the CCO or other compliance personnel involved in addressing
conflicts to

Record and track all existing and
potential material conflicts of interest along with the firm's
response to these conflicts; and

Discuss directly with each client, in
person or over the phone, all material conflicts of interest to
ensure the client understands the firm's conflicts prior to
commencing trading activities.

Relationship Disclosure Information

The failure to disclose conflict information forms part of the
ASC's broader concern about Relationship Disclosure Information
(RDI). Section 14.2(1) of NI 31-103 requires that registrants
provide clients with all of the information that a reasonable
investor would consider important.

Consistent with CSA Consultation Paper 33-404, the ASC seeks to
raise the bar on relationship disclosure by ensuring that clients
have read and understood RDI. The Report accordingly suggests
including fields in the KYC form for the client to acknowledge that
each section has been discussed with the dealing representative and
is understood. This would significantly increase the number of
fields in a KYC form that need to be specifically acknowledged by
the client, adding further time and compliance cost to the process.
It also adds uncertainty with respect to how and when such RDI
acknowledgments must be updated.

RDI should be provided in a single document that discloses all
fees payable by the client, including those relating to custody for
RRSP and TFSA accounts. RDI must be kept up to date and should be
delivered in a timely manner. The ASC also emphasizes the
importance of drafting RDI in plain language.

Reporting to Clients

The ASC seeks to impose an onerous a requirement for EMD clients
to acknowledge receipt of trade confirmations and client statements
(e.g., by obtaining an electronic notice of delivery). The ASC also
puts its gloss on certain market practices:

Subscription agreement as trade
confirmations – A subscription agreement should not be
delivered in lieu of a trade confirmation unless it includes
information that meets the trade confirmation requirements and
delivery meets the timing requirement; and

Third-party trade confirmations and
client statements – EMDs should not rely on trade
confirmations and client statements provided by an issuer or
custodian unless oversight procedures are in place.

Other Compliance Issues

Additional issues that were identified included (among others)
inadequate supervision and disclosure of outside business
activities, use of non-compliant trade names, failures to inform
the ASC about significant changes to a firm's business model,
failures to update information on the National Registration
Database, allowing registerable activities to be performed by
non-registered individuals, and an absence of policies regarding
the allocation of investment opportunities among clients.

Conclusion

The above is only a selection of highlights from the Report,
which is worth reading in its
entirety. The ASC recommends that
firms use this Notice to strengthen their compliance with Alberta
securities laws. Although the Report is focused on Alberta-based
EMDs, much of the guidance draws on previous CSA guidance and is
consistent with the themes set out in CSA Consultation Paper
33-404. The best practice guidance seeks to raise the bar in
several areas and may over time be taken into consideration by
other CSA jurisdictions.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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